Money Substitutes and Velocity

The Fed's performance in stabilizing the growth of nominal spending was abysmal

Really, read Beckworth's post. The graphs are more important than the text. My comments will be in Q&A format. The issue is whether we should think of the Fed as offsetting velocity shocks or we should think of changes in velocity as offsetting monetary shocks.

1. Why did money and velocity move in opposite directions for the most part from 1980 - 2007? Beckworth's answer is that the Fed did a great job of offsetting shocks to velocity. The answer that I would give (and I suppose James Hamilton is with me, although I do not want to put words in his mouth) is that nominal GDP was doing its own thing, so that when the money supply changed, velocity moved in the opposite direction. I would say that velocity was able to offset monetary shocks.

2. Why did money and velocity show less mirror-image behavior from 1960 through 1979? Beckworth's answer is that the Fed was doing a lousy job of offsetting velocity shocks. My answer is that velocity was less able to offset monetary shocks.

The reason that velocity was less able to offset monetary shocks in the 1960's and 1970's was that the medium of exchange was more clearly defined. (a) There were interest ceilings on checking accounts (for most of this period, checking accounts were not allowed to pay any interest), so there was a definite difference between money and interest-bearing assets. (b) Most people had fewer alternatives to using cash or checks. The idea of pulling out a credit card at a grocery store or fast-food restaurant was unheard-of.

Thus, the institutional setting of the earlier period was one in which the substitutability of the M1 money supply and other financial assets was low. This made it difficult for people to offset monetary shocks with velocity shocks, and it allowed the money supply to affect nominal GDP.

Since then, the substitutability between the M1 money supply and other financial assets has been rising. As a result, velocity shocks tend to offset monetary shocks, and changes in the money supply are less likely to affect nominal GDP.

I do believe, however, that if the U.S. government were really determined to have inflation in the short term, that could be accomplished. If we printed dollars and used them to by foreign assets in massive amounts, that would to the trick.

Such a policy would, in a world of sticky nominal wages, make U.S. production more competitive and reduce unemployment. Given that we have a bad unemployment problem and no inflation problem, this seems like a plausible policy to try, although in a larger sense it risks undermining the de facto dollar standard on which world trade has depended since the second world war.

Comments and Sharing

"Such a policy would, in a world of sticky nominal wages, make U.S. production more competitive and reduce unemployment. Given that we have a bad unemployment problem and no inflation problem, this seems like a plausible policy to try"

OK, I am at a loss here.

In theory demand = profits = job creation. So now we have a situation where demand is off from the peak but corporate profits are back to the peak yet companies still dont feel like hiring.

So our answer is to reduce real wages. The theory is that if we pay people less companies will eventually have to hire them.

Why should labor bear the brunt of the adjustment? The solution above basically amounts to - "make corporate profits so incredibly high - above previous record highs that they have no choice but to hire now that wages have fallen.

That just seems unfair in a country that already feels very poor to labor.

This is the kind of post that makes me think you don't understand the logic of monetary equilibrium.

You need to "drop the we". Printing money makes people *more* likely to hold money? In certain perverse circumstances (such as exchanging 0 interest assets for money when money bears no interest) sure, but as a general rule? no. Yet this is what you implicitly postulate. "Offsetting changes in the money supply" is not a goal for individuals.

I cannot stress this enough: it's very difficult to make sense of macro issues without starting from a micro perspective. Velocity is not a feature of individual's decisions, it's a summary statistic of the economy. Starting from macro statistics is a recipe for confusion.

Money traditionally is both a riskless, liquid asset and a medium of exchange and 50 years ago M1 served both purposes. Now, as you point out, money substitutes are ubiquitous and the economy can function quite smoothly with very low levels of "legal tender." The ratio of GDP to M1 seems to be no more interesting than the velocity of toothpick consumption.

Something else has happened. The linkage between fed activities and the supply of money substitutes has become weak and unpredictable due to the emergence of the shadow banking phenomenon. Shadow banking converts any type of AAA, non-information sensitive liquid asset into these money substitutes.

Money has become endogenous. We should start to think of the fed as tinkering at the margins with the relative competitiveness of regulated banking and shadow banking. From this perspective it is difficult to see what quantitative easing accomplishes. Buying T-bonds may even be contractionary if it has the effect of turning collateral in shadow banking into reserves in a less efficient regulated banking system.

Monetary policy has become impotent, not because of any Keynesian liquidity trap, but because the financial intermediation process that creates money is no longer under the effective control of policy makers.

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